No one has ever asserted that the bankruptcy arena is for the faint hearted. On the road to development of a plan of reorganization (or more commonly these days, a sale of all of the debtor’s assets), there can be bruising fights between the debtor and its lenders, trade suppliers, unions, and landlords and between the tranches of senior and subordinated debt. Often these dust-ups are caused by the debtor’s attempt to minimize its liabilities by forcing creditors to take less than they are owed, or paying them in TBDs—tiny bankruptcy dollars.

Reducing claims, however, is not the only game in town. Many times what is afoot is for the debtor to seek to enhance the value of what it owns regardless of who is hurt in the process. If what the debtor owns is intellectual property rights such as patents, copyrights, trademarks, and the like, it is the licensee who may be most at risk.

A short summary of bankruptcy law is necessary here.1 Section 365(a) of the Bankruptcy Code says that a debtor2 can assume or reject “executory contracts,” which are largely understood to be contracts where each side still has meaningful performance due. A promissory note is not an executory contract because one side (the lender) did everything it needed to do when it made the loan. Only the borrower must still perform by paying the loan back. A supply contract for goods, on the other hand, is an executory contract because one side is required to continue to supply the goods and the other side is obligated to pay for them.

Debtors typically reject executory contracts because they are burdensome liabilities. A supply contract, for example, may be rejected because the debtor is the consumer of the goods and is locked into paying an above-market rate. But contracts can also be rejected because the debtor may see a better opportunity elsewhere. If the debtor was obligated to supply goods for below what the market now dictates, it might want to reject the contract so it can enter into a new contract with a third party willing to pay a higher price. Of course, this is unfair to the party left behind in the rejected contract, who was fully performing its side of the bargain.

Although now almost 30 years in the past, the epitome of this unfairness is the case of Lubrizol Enterprises, Inc.3 in which the court allowed a debtor licensor to reject a patent license, leaving the licensee, who had fully paid for the licensed rights and needed them in the operation of its own business, irreparably harmed with only an unsecured claim that would be paid in TBDs as solace. The justification for this catastrophic destruction of the licensee’s rights was so the debtor could relicense the patent rights to someone else and be paid twice for the same license.

Even Congress could not ignore the imbalance of rights highlighted in Lubrizol and reacted by amending the Bankruptcy Code in 1988 by enacting Section 365(n). Section 365(n) prevents an intellectual property licensee’s loss of some of rights upon rejection of the license by the debtor although it does so by offering a Hobson’s choice. The licensee may elect to allow the license to be terminated and assert whatever claims against the debtor it may have (subject, of course, to bankruptcy law and payment in TBDs), or it may elect to retain its rights. If it elects to retain its rights, it must continue to make all royalty payments and cannot offset any of damages it suffered against those amounts.

Although much better than the result in Lubrizol , Section 365(n) still means plenty of licensee pain following rejection. For example, the only rights the licensee can retain are those that existed when the bankruptcy case commenced. If the intellectual property is unfinished—software still being developed, a movie not yet in production, sequels not yet written—Section 365(n) offers no help and the licensee will lose rights to those assets. Even if the licensee has something of value during the bankruptcy case, any subsequent modifications or improvements, even such things as a patch for a bug in software, need not be provided to the licensee despite what the license may provide. If the license doesn’t allow the licensee access to what is needed to take full advantage of the intellectual property, such as the source code, trailers, or art work, Section 365(n) will be of no assistance. Finally, Section 365(n) is not self-executing. A licensee not paying full attention to its licensor’s bankruptcy case will lose Section 365(n) rights if they are not timely exercised.

Section 365(n) has another critical problem. It only applies to intellectual property as that term is defined in the Bankruptcy Code, not in the broader sense used in business and in art.4 Most glaringly, the Bankruptcy Code does not include trademarks as intellectual property, so licensees of those rights cannot even invoke Section 365(n). Lately, however, that appears to be a good thing. Several courts, have found ways to protect the rights of a trademark licensee against the debtor licensor’s attempted rejection and retrieval of licensed rights. In Exide Technologies5, for example, the Court of Appeals found a way to declare the license at issue not an executory contract, and thus not even subject to rejection. The concurring opinion went even farther and held that even if the license could be rejected, it did not mean that the debtor could regain the intellectual property free of the licensee’s rights. Rather, the concurring opinion stated that rejection might be a breach by the debtor but otherwise of no impact on the licensee.

Last year, the concurring opinion was followed (and expanded) by another Court of Appeals in the Sunbeam case6. In Sunbeam, the court revisited Lubrizol, disagreed with it, and held that a trademark licensee continued to have the right to use the mark following rejection. Indeed, Sunbeam means that trademark licensees, forgotten by Congress when it enacted Section 365(n), may be substantially better off than licensees of other types of intellectual property and that other licensees may start to waive the protections of Section 365(n) for the broader rights announced in Sunbeam.

While Exide and Sunbeam may have suggested a safer world for the rights of intellectual property licensees, a new threat has materialized. Here again, a short exposition of bankruptcy law is required. Section 363(f) of the Bankruptcy Code allows a debtor to sell its assets “free and clear of any interest in such property” subject to certain conditions. The intent of Section 363(f) is that a buyer will pay more for assets if it does not have to worry about known and particularly unknown liens and other claims to the assets. The more value that is realized, it is widely thought, the better for all the creditors including those whose interests were stripped away in the sale. Those “interests” include intellectual property rights.7

Does 363(f) right to sell free of clear to intellectual property interests trump Section 365(n) provisions allowing a licensee to retain its rights in licensed intellectual property? Does it trump the rights protected in Exide and Sunbeam? Surprisingly, we don’t know. In a very similar context, a court ruled that the debtor could sell property it owned that was leased and strip a tenant of its rights despite Bankruptcy Code Section 365(h) that expressly protects tenants of a rejected lease.8 In large measure, however, the case was decided on the fact that the tenant failed to object, which was deemed akin to implied consent.

More recently, the buyer of the Blockbuster video assets in the United States sought to prevent the Canadian subsidiary (whose assets it had not purchased) from using the Blockbuster name and other intellectual property. Despite the fact that the subsidiary had a written, fully paid-for license to use the intellectual property, the buyer asserted that the Canadian’s affiliates rights under Section 365(n) and otherwise were extinguished when the assets were sold “free and clear” without objection by the subsidiary.9 That the subsidiary had no practical ability to object to a sale its own parent was promoting was ignored.

If the buyer’s position had been adopted by the court, it would have been catastrophic to the rights of the Canadian affiliate and its creditors. Not surprisingly, the matter settled leaving the issue unresolved. But, it is only a matter of time before another debtor or another buyer seeks this new avenue to destroy a licensee’s bargained for and valuable rights. What can a licensee do in the face of this new attack?

First and foremost, regardless of how ironclad the contract, the licensee must closely monitor the licensor’s bankruptcy case. It is very easy to request notice of all activity in the case and have all the pleadings and other papers filed in the case sent directly to the licensee by email, fax or mail. Whoever is monitoring the case needs to look for motions to reject executory contracts and/or motions to approve sales of assets. Active participation in the bankruptcy case may be required. If the licensee finds its name in those motions, it needs to assess the best course if it wishes to retain its rights uninterrupted and in full. The licensee could take the position that the license is not executory and the debtor is not entitled to reject it. Or it could timely exercise its Section 365(n) rights by providing the notice required. Or it could object. There are several grounds for an objection to a sale free and clear of intellectual property subject to a license and it could prevent any court from finding an implied consent to the destruction of those licensed rights.

Perhaps if some court issues an opinion as dramatic as Lubrizol Congress will again step in and fix, ideally better than it did with Section 365(n), the latest attack on licensees. Until then, licensees, be alert and keep your shields up. Pamela Kohlman Webster is Chief Financial Officer and Chief Operating Officer of Buchalter Nemer and a Shareholder in the firm’s Insolvency and Financial Solutions Practice Group. She can be reached at 213.891.5030 or pwebster@ buchalter.com.

1 The bankruptcy law discussed throughout this article is the federal United States Bankruptcy Code, found at title 11 of the United States Code.

2 The statute actually gives these powers to a trustee but by operation of other sections of the Bankruptcy Code these powers are available and often used by Chapter 11 debtors in possession of DIPs.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.

- hide

Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.